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NBR’s decision mostly irrelevant unless you are a bank or the Government

I admit NBR surprised me today. I did not think it had the balls but most of it I thought it cared more about the real economy than about the political shenanigans. The only immediate effect of today’s decision is an instant 25bp profit for local banks financing the Romanian government debt. Of course, there is hope from the NBR that such a favor will be returned and local banks will continue to fund the increasing local debt at a lower rate. As this all happens at very short maturities the effect for all of us is that we will have to pay for it through higher taxes in the future.

The decision from the NBR theoretically should only be judged relative to the deviation of inflation forecast from target. The graph below shows NBR’s view of how inflation will deviate from target in the following 8 quarters. However, inflation has surprised positively – lower than expected – since these estimates were made. Thus, theoretically NBR is adjusting monetary conditions by taking into account the most recent information to make sure inflation will be at target, 3% in 8 quarters from now.

This is the theory. One major assumption here is that there is a relationship between the key policy rate and inflation over the forecasting horizon. Unfortunately this is not true (see my Monetary Policy in 2012).

What should happen when NBR lowers the key rate?

It depends on the instrument. In very simple terms NBR uses few instruments to control short term liquidity in the money market. From there it expects the market, i.e. banks, to do the job of transmitting the effects of monetary policy decisions to the real economy. In theory, a lower key policy rate should mean a more relaxed monetary policy. The immediate effect should be seen in the money market. This is where the problems arise for the NBR. But as you can see in the graph below after NBR lowered the key rate from 6.25% to 6% on November 2nd 2011 monetary conditions in the money market have gotten worse not better. The available average liquidity has in fact decreased and so did the number of transactions.

Furthermore for those expecting lower lending rates, via the credit channel, evidence shows that ROBOR rates used as benchmark for pricing loans have actually jumped and remained high right after NBR lowered the key policy rate on November 2nd 2011.

These graphs show that there is a break down between theory and practice when it comes to implementing monetary policy in Romania. Just by lowering the key rate does not mean that monetary policy is now loose. There are 2 main reasons for this:

1) NBR’s is managing short term liquidity to control RON volatility

2) Related to first, NBR unsterilized interventions create too much volatility in the money market with the risk that at some point banks will have to use the LOMBARD facility, currently at 9.75%, to finance themselves. (See graph below)

Nevertheless, someone will profit from a lower key policy rate. In the first instance banks and then Romanian Government. The banking sector is financing the Government deficit at short maturities at rates around 7%. From next week, they will finance those “investments” at 5.75% instead of 6%. It does not seem a lot but when we talk of billions of RON it adds up. Of course the expectation is that some of those profits will be passed on to the Government via lower interest rates for the public debt.

So, the banks win and the government wins. In this environment do you see a reason for the government to cut expenditures or for banks to lend to the real economy? I do not.

Today’s interest rate decision looks great on paper and in accordance with Inflation Targeting theory. Unfortunately, in Romania the NBR does not target inflation, at least directly. Also, the key policy rate is irrelevant when the real cost of short term funds can go from 1.75% to 9.7% within few days.

Finally, what good is playing with the RON rate when the economy, including the government, is borrowing and making contracts in EUR?

P.S. My advice is that if you want to know what happens to the short term funding cost watch the EURRON. Also, if NBR is serious about making RON lending a competitor to EUR lending then it has to make RON cheap. This means lower RMO for RON and some more depreciation. In the same time it has to make EURO expensive. The best way to make EURO expensive in Romania is to show that it carries risk, FX risk.

6 thoughts on “NBR’s decision mostly irrelevant unless you are a bank or the Government”

So it is a win win situation for banks and government and neutral (this means worse in future) for the real economy. The question is why the NBR is not willing to cut more and quickly the interest rate or at least to have a dovish speech. It would be a win situation not only for banks and government, but for the real economy. The NBR wants a weaker RON and at the same time it wants to control its volatility. Besides the traditional rigidity of NBR, we have election this year and it should be more careful. That is bullshit for me and should be also for NBR. However, as inflation estimates are in favour for lower interest rates (even though there is a lack of correlation), I suppose the NBR’s fear comes from other reasons. I saw few days ago a speech of NBR governor in Romanian Parliament dating from october 2008. It was pretty funny (or not) to see how poorly were the assessments concerning the crisis, especially regarding the impact of crisis on Romanian economy and local banking system. Therefore, I think that now the NBR tend to overrate the potential damage of eurozone sovereign debt crisis on RON and probably the NBR feels that there is a point where it could lose the control of RON. I think this is not the properly way to approach the crisis.

Let’s bet that starting with spring food prices go up. Let’s also bet that for some lending products we will soon see loans in lei cheaper than loans in eur (PC in lei cheaper than the standard eur mortgage)…so that kinda’ adds a whole new perspective to the move today, huh?

@JB
I do not understand you. Are you saying that because of today’s interest rate decision we will see an increase in food prices and RON lending?
If you expect food prices to go up than today’s move does not make sense. NBR should be pro-active and make sure CORE inflation does not rise so the food price increase keeps future inflation close to target.
I will be very happy to see mortgages in RON cheaper than in EUR. Please come back in the spring with the evidence. Until then I remain a skeptic.

Not exactly so. Foodies go up because of the draught (god protect us of any turbulences with price of oil, fuels). Move today leaves them space for maneuvre later.

RON lending is not at hand, but they’d definitely like to see more right? So they are supporting it. At the end of day what do banks lend currently:state, prima casa & large corps (exporters?) first two qualify for cheaper ron lending

@JB
NBR does and should not respond to first round supply shocks within an Infaltion Targeting regime. I highly doubt that they had in mind this scenario, but maybe you know something I do not. My guess is that NBR will live with inflation above target this year in order to keep costs for public debt down.

On the RON lending they are sending mixed signals. The MM does not work beyond 3 months. All the liquidity is available only at very short maturities which is no use to mortgage funding. Also, you forget about their chronic hate of RON volatility. They will keep intervening which will make short term money market rates (i.e. funding) too volatile to be used for long term lending.

Yes currently lending goes to corporates, state and prima casa. The first borrows in EUR and it will as they have access to hedging or believe in the NBR put. The state borrow short term so I hope you do not want o compare mortgages in EUR with 6 months t-bills in RON. In fact the Romanian government borrows in RON cheaper than the Italian or Spanish Government in EUR even though Romania is rated many notches below those two countries. That tells me that yes a central bank will finance a deficit but that does not mean that the same central bank will support the same price for mortgages. Regarding the third, prima casa, what can I say? Should we consider a subsidized scheme as a sign the credit channel works? I will not.
Before we see mortgages in RON replacing the ones in EUR local banks need to deal with the EUR mortgages in their portfolio which are not doing too well.

To make a long story short, just because the Romanian government borrowed in the international market at 6% once in a year does not mean that it is the price at which it would borrow if it would have done the same exercise every month. In fact if we take the average price from their two attempts last year, 6% and infinity (they could not get any offer in US ), then we see that the real price for Romanian debt is much higher than publicly acknowledged.